FX ‘picking’, who is the one to watch?

For the past couple of months, volatility has declined in all asset classes and traders (and algos) have switched to a range trading attitude. If we have a quick overview of the market, we can see that the S&P500 is still fighting against the 2,100 level, the VIX is gradually approaching its crucial 12 level, core bond yields are trading a bit higher (Bund is up 10bps, trading at 16bps) and EURUSD is trading in the middle of its 1.05 – 1.10 range.

However, in a more detailed analysis, we heard some noise lately that trigger a bit of movements in the FX market.

1. SNB talks, first round…

The first one was the CHF move. A few days ago, I posted on my twitter account a chart (see tweet @LFXYvan on April 19) that I thought could be problematic for the Swiss economy (i.e. SNB). At that time, EURCHF was gradually approaching the 1.0250 level, down from 1.08 a couple of months ago (5% appreciation).

Then, a couple of days later, SNB comments sent he Swissy tumbling, with EURCHF and USDCHF up 150 and 200 pips respectively. In its comments, the SNB announced that it reduced the group of sight deposit account holders (bank account through which transfers in the form of cashless payments and cash deposits and withdrawals can be effected) that are exempt from negatives rates, therefore transferring the ‘negative carry’ to its clients and in hope that Sight Deposits are reduced.

Looking at the charts, it seems that it wasn’t enough to force investors to run away from the Swiss Franc and I think we are on the path to retest new lows on EURCHF and USDCHF. With Swissy becoming once again the safe-haven asset since the end of the floor in mid-January, SNB Jordan will have to do more to prevent the exchange rate from appreciating ‘too much’.

2. Cable: will the ‘hawkish’ minutes floor the currency losses ahead of the UK general election?

Yesterday’s BoE minutes trigger a bit of appetite for the pound and sent Cable to a 1-month high of 1.5070. As you can see it on the chart below, the currency is now flirting with its 50-day moving average, an important resistance that could halt the pair’s late bullish trend.

GBP

(source: FXCM)

To be honest, I didn’t understand the sort of positive GBP reaction based on the central bank’s report. If we look at the big lines, the Committee voted unanimously to keep the Official Bank Rate steady at 0.5% (as expected), and in the 23rd section, it says that policymakers were expecting the 12-month CPI rate to fall into the negative territory at ‘some point in the coming months’. It sounds more neutral (if not so, slightly dovish) than hawkish to me.

With the (uncertain) general election coming ahead, I’d rather keep a short position on Cable, especially at current levels. Conservatives should keep a tight stop at 1.5160 for a first target at 1.4750, however I would widen the room there and suggest a stop at 1.5250 (RR of 1.3).

3. Follow the CAD move

Another mover was the CAD, alongside rising prices for oil, which surged by 6 figures to hit a three-month low of 1.2090 on Friday before coming back to 1.22 (against the greenback). With the Western Canadian Select June futures trading at a 11.50 spread against the WTI and higher than expected inflation rate (1.2% YoY in March vs. 1% consensus), the probability of another 25bp cut from the BoC in order to counter a lower growth economic forecast was revised (lower) by the market. It could potentially cap USDCAD on the upside, first resistance is seen at 1.2280, then the second stands at 1.2400. I would be comfortable with a little short position on USDCAD, targeting 1.2180 at first (stop above 1.2360).

CAD

(Source: FXCM)

4. Trade the Yen from a ‘Technicals’ perspective

I will finish this article with the Yen and Japan latest news. We saw earlier this week that Japan Trade Balance saw a tiny JPY3.3bn surplus (vs 409bn deficit expected) after 48 months of trade deficits. Even though it should be considered as good news (for a country which is expected to see a current account deficit for the first time in 34 years), the reason of that tiny surplus was driven by a collapse in imports, that plunged by 14.5% YoY (the most since November 2009). The Good news for Abe (and Kuroda) is that the stock market closed above the 20,000 level this week for the first time in 15 years, making a least one of the arrows – monetary stimulus – work.
As the Yen still remains one of my favorite currencies to watch on a daily basis, I had a lot of conversations with some friends of mine, and we (almost) all agree each time that the BoJ will lose completely control of its currency in the medium/long term. If you look at Japan core figures (debt-to-GDP ratio of 240% according to the IMF, a declining population with more than 25% Japanese aged 65 or over – out of 127ml, massive stimulus as a share of the country’s GDP…), the problem is easily spotted and the biggest ‘opportunity’ will be in the currency market in the medium term.

However, I am more skeptical (i.e. less comfortable) with the short-term trading. Now that the currency has passed its safe-haven status to the Swissy (see tweet @LFXYvan on March 24), I am usually looking for some buy-on-dips opportunities. Being short USDJPY sometimes scares me in the way that I don’t understand how the market interpret good news or bad news in Japan (therefore I always keep a tight stop for short positions).

One thing I am still comfortable in saying that, in an intra-day basis, USDJPY and the equity market (SP500) are still ‘breathing’ together, therefore one of them will ‘carry’ the other.

The wide range on the pair would be 115.50 – 122, but based on today’s volatility I am looking at the 118.30 – 120.80 window. Any breakout of the window could lead to another ‘readjustment’; something I am going to watch closely. If the currency keeps approaching the high of the range, it could be worth going short at 120.60 with a stop above 121.00 and a target at 119.50.

JPY

(Source: FXCM)

June rate hike? What Yellen (and the Fed) faces…

I have to admit that by just looking at the government bond yields (see appendix), I am asking myself a lot of questions about the stability of the economy and the financial markets. However, one particular point that matters the most is the Fed’s June rate hike.

Therefore, this article aims to give an update on the four major risks that can lift-off the central bank’s monetary policy decision for later this year, which are the following topics:

  • China slowdown
  • Dollar strength
  • Oil prices
  • Grexit: Greece and all its 2015 payments
  1. China Slowdown

It is clear that commodity prices have dropped dramatically over the past year based on a lower than expected Chinese growth (i.e. global demand). If we look at the last figures, analysts expect China to grow by approximately 7% in 2015, down from the last 7.5% projection (in late 2014). Last week, we saw that the economic output grew 7% YoY in the three months of 2015, down from 7.3% in Q4 last year and now standing at its slowest rate in six years. What really concerns me is that I read several times the word ‘approximately’ in analysts predictions of China 2015 growth, this means that we could see an actual lower than 7% figure, especially in the middle of this geopolitical war.

In the housing market, it looks like the economy is experiencing a sort of ‘real’ correction: if we look at on of Chinese Housing Market ‘benchmark’ – China 70-city Home price change – the last report showed that house prices decreased 6.1% YoY in March, its eighth negative print in a row and the biggest drop in history.

It is hard to believe that after a 15tr USD increase in total Chinese Bank assets since September 2008, the economy is still struggling to achieve a healthy growth. The obvious response from Beijing officials was to cut its Reserve Requirements Ratio by 1% to 18.5% (last one was a 50bp cut in early February), ‘flooding the market’ with liquidity and participating – like the rest of the World – to this massive monetary stimulus.

What the PoBC cut a sort of ‘preparation’ to the Fed’s action?

Maybe I know too little about the Chinese economy (and history), but it is curious too see that some financial experts have a totally different interpretation of China.

For instance, in the last discussion that I had with a (very) experienced economist, I asked him ‘Where do you see the most interesting opportunities at the moment for medium term investments?’

He answered me: ‘Well, there are three countries you should invest in: China, China and China!’ He started his quick analysis about the massive internal migration of young new dwellers moving from rural to towns and cities (between 10 and 20 million each year according to NBS). Chinese major cities will host approximately 60% of the country’s total population (permanent urban residents) by 2020 (slightly above 50% now), therefore playing in favor of Chinese Fixed assets, companies’ valuation,… However, I was asking myself: ‘What about work conditions and salary increase? We learned from the last GFC that you can’t reach a sustainable economy with a divergence between median annual incomes and home prices. In addition, you can’t build a strong economy based on speculative stories and artificial growth (look at the Spanish situation now after the correction in the housing market).

Moreover, this scenario was based on a strong assumption that relations between China and the US remain stable (i.e. no pressure from the West to abolish the exchange rate peg). This is clearly not obvious, especially in this new (sort of) Cold War between East and West. If we look at the US Treasury website, we can see that China has reduced its US Treasuries by 50bn USD over the past year (its US holdings stand at 1.224Tr USD as of February). If this trend continues, pressure from US officials to drop the peg will be more and more a serious debate.

Besides that digression, it seems that we are going to see some downward revision in China, which will obviously be a persistent topic at the next FOMC statements.

  1. Dollar strength

The topic that I love to discuss is the Dollar strength. Described as the most crowded trade of the year, it is clear that a constant strengthening greenback will be problematic for the US economy, especially now that the Fed has stepped out of the bond market. Even though we saw a sharp reduction of the government’s deficit in the last two fiscal years (the annual US budget deficit fell from 1.1tr USD for FY12 to 483bn USD for FY2014 as you can see it in the chart below – equivalent to 2.8% of the country’s GDP), the US still runs large current account deficits (coming from consistent trade deficits) which forces them to rely on external funding.

USdeficit

(Source: WSJ)

A strong dollar wouldn’t help to ‘redress’ the balance of trade (i.e. exports are less competitive), and will obviously decline companies’ sales and reduce the economic output. Pessimist Atlanta Fed forecast a zero-percent growth for the first three months of this year, down from 1.9% in early February. The market is more bullish anticipating a 1.4% rise.

The July Fed Funds Futures implied rate is at 15bp, while September and December are trading at 21bp and 34.5bp respectively. From that perspective, I will opt for a September move (vs. June).

  1. Oil prices

As you know, oil prices fell sharply in the second half of last year, bringing to an end a four-year period of stability around $105 per barrel. If we look back at prices’ history since the early 80s, there has been four other relevant declines prior to this one:

  • Increase in oil supply and change in OPEC policy (1985-86)
  • US recessions after the S&L crisis in 1990-1
  • The Asian crisis of 1997
  • The Great Financial Crisis 2007 – 2008

Today, the causes of the Sharp Drop could be explained by multiple factors: a change in OPEC policy objectives (no intervention from Saudi Arabia in the last OPEC meeting on November 27th last year), increasing production (US Production of Crude Oil now stands above 9ml barrel/day, up from 5ml 7 years ago post GFC), receding geopolitical concerns about supply disruptions in the Middle East and between Russia and Ukraine, a sinking global demand and a US dollar appreciation. It is hard to define which of these factors was the most important, however I would say the expansion of oil output in North American due to the US Shale revolution (and Canada oil sands) and a declining global demand both weighed on oil prices.

Although low oil prices (and other commodities) is seen as a sort of stimulus for consumers by analysts, I am very confident that it is also the explanation of the late decrease in inflation expectations in all the Western countries. The table below shows you the Consumer Price Index of the major economies:

Country

March

July

US

-0.10%

2.00%

UK

-0.10%

0.40%

EZ

0.00%

1.60%

Japan

2.2% (February)

3.40%

Even the 5y/5y forward swap rate, what central banks watch as an indication of inflation expectations, has fallen to unprecedented sub-2 percent levels in the US, which is going to be problematic as Yellen and (most of) the Fed’s Board have considered that it is time for monetary policy tightening – the so-called neutrality.

In addition, low oil prices could also be a burden for all the high leveraged shale oil companies in the US. The chart below (source Bloomberg) gives us a quick idea of where oil prices have to stand so that shale companies are (at least) breakeven. According to the sell side research, breakeven prices for US shale oil are within the $60-$65 window. WTI May futures contract is still trading below those figures at a shy $56.

ShaleBreakeven

(Source: Bloomberg)

  1. Grexit and the contagion effect

With the 10-year yield now trading at 13% (and the 2Y at 29%), it is clear that the market is anticipating disappointing negotiations between the new Greek party and the Troika. There are lots of good articles that came out lately about Greek’s situation, but that could easily be summarize by the chart below. This clearly shows that there are going to be a lot of meetings with European officials before the Summer, and the Tsipras government will have to innovate its list of reforms in order to free up funds and service its short-term obligations.

GreeceInSHort

(Source: IMF)

What’s next then? Let’s assume Greece makes it way through the summer (the two 3bn+ payments to the ECB) without catching a cold, this is only the 2015 chart and there are plenty of more years to come. No borrowing from the financial market and an unstoppable increasing debt (see article Pocketful of Miracles). A situation that could only deteriorate in my opinion…

In the latest news, Bloomberg reported that the Greek government issued a legislative act yesterday that requires public sector entities to transfer idle cash reserves to Bank of Greece (i.e. capital controls) as the country is willing to serve its next €1bn debt obligations to the IMF next month.

To conclude, we may see a symbolic 25bp hike at the June FOMC meeting, however I am certain that we are far from the so-called long-run neutrality rate of 3.5%-4%. If the weak global macro environment persists in the medium term, we are constantly going to see downward revision in the Fed’s dot plot.

Appendix: Government bond yields

BondYields

Yemen conflicts, on the edge of a civil war…

For the past few of months, conflicts in Yemen have been making the headlines of the daily news as the situation seems to worsen continuously. In this article, I gathered some information from different sources to help me understand the actual situation in Yemen, its origin and why it matters to so many countries.

Yemen is one of the poorest countries in the Middle East with very limited natural ressources, with a GDP of roughly 36bn USD according to the World Bank (vs. Saudi Arabia is 750bn USD). Its inhabitants (24.4 million) are divided into two principal Islamic religious groups: 55 – 55 % Sunni (predominantly present in South and South East) and 42 – 47% Shia (North and NorthWest). Therefore, Yemen contains a high ratio of Shia Muslims compare to its neighbour Saudi Arabia as you can see it on the picture below.

 MiMS

(Source: Financial Times)

Quick recap: When did the schism begin?

It all started when the Prophet Muhammad died in 632 AD. As he left no designated male heir, disagreements over the succession to Muhammad as a caliph of the Islamic community started to rise, leading to two opposition groups:

  • Shia, the minority accounting for 10 – 15% of the World’s Muslims
  • Sunni, the majority accounting for 85 – 90%

Over the centuries, Shia-Sunni relations have marked by both cooperation and conflict, which brings us today to the Yemen crisis. In recent months, Yemen has descended into conflicts between several different groups, pushing the country into the ‘edge of a civil war’.

Given the complexities of the conflict in Sa’dah, I will try to define which groups are present in Yemen and which country is related to that conflict. Sa’dah conflict, Yemen’s government against the Zaidis, originated in Northern Yemen in June 2004 and has been running since then. Sa’dah region (see appendix), once the seat of power of Yemen, has often been the centre of battles for political power in the country.

Houthis’ origin

A single state within the borders of what is now the Republic of Yemen had never existed before 1990. In past centuries, a variety of states existed covering different part of the country. On September 26, 1962, the last imam of Yemen, Muhammad al-Badr, was overthrown by Abdullah al-Sallal, founder and President of the Yemen Arab Republic (YAR, Red part in the map below).

Yemen

For the next six years, Badr and his alliance of northern tribesmen fought a guerilla war in the mountainous highlands against Egyptian soldiers who arrived in support of the Yemen Arab Republic. One of the leaders of the northern tribal alliance (Badr allies) was indeed the elder Sheikh Hassan al-Houthi. At that time, the northern tribesmen were getting support from Israel in their fight against Egypt (which was then Israel’s principal enemy). In 1966, Israeli assistance to Yemen tribesmen ended (increasing concerns for safety) and Badr eventually lost the civil war in 1968. Badr and his tribesmen (including Houthis) joined the YAR in 1970.

In addition to the political divergence, religion divides Yemen’s inhabitants. The Houthi are followers of Zaydism (Zaydi Islam), a Yemeni Shia where its adherent are known as Fivers for their recognition of Zayd ibn Ali as the fifth Imam. Zaydi Muslims represent 40% of Yemen’s population (total of 23 million roughly), and the remaining majority belongs to the Shafi’i branch of Sunni Islam. Prior to Yemeni unification in 1990 (YAR and South Yemen), the northern half of majority Zaydis and the southern half majority Shaffi’is have remained as two separate regions.

Despite Western papers linking Iranian-Saudi tensions over Yemen as yet another example of a Shia-Sunni conflict, the Houthi movement is not a manifestation of an international religious conflict. Big supporters of the 2011 Arab Spring uprising against then President Saleh, the Houthis are fighting for a more transparent government and there were clearly not satisfied by the new President Hadi. As a reminder, Yemen’s poverty rate reached 54.5% in 2012 (World Bank); the country is victim of water scarcity, low industrial potential. In addition, the Yemeni government is the 10th most corrupt in the world according to Transparency International. Even though the war has been active for almost 11 years now, tensions have risen drastically since summer last year (series of demonstrations in August last year in the capital Sana’a against increased fuel prices up to 90%).

Who is involved?

Even though the country is poor in resources, there are a lot of countries involved behind Yemen. This map from news network Aljazeera summarizes the current situation pretty well. Therefore, you can see that the major developed economies are involved into that conflict, putting US-backed middle countries (Saudi Arabia…) against the classic Iran/Russia/China.

WhosFor

(Source: Aljazeera)

What are the consequences for oil?

As of January 2014, Yemen had proved reserves of oil totalling 3 billion barrels (far from the Saudi 270bn barrels proven reserves) according to EIA. It has two primary crude streams: the light and sweet Marib stream and the medium-gravity/more sulfur-rich Masila stream. Masila Basin located in the southeast holds more than 80% of the country’s total reserves.

However, its production has decreased massively since 2001 from 450,000 barrels per day to 100,000 bbls today mainly due to the country’s aging fields and frequent attacks on its oil infrastructure (see pipeline system, 10 to 20 yearly attacks over the past ten years).

EIAYemen

(Source: EIA)

Clearly, a cut in oil production from Yemen won’t affect oil prices, however here is a reason that could potentially boost the prices. Roughly half of the world’s oil production is moved by tankers on fixed maritime routes, and a couple of oil transit chokepoints are located in the Middle East close the countries currently ‘under fire’. As you can see it on the chart below, the first one is the Strait of Hormuz located in the Persian Gulf (Iran is the border there), which sees 17 million barrels of oil moved per day (EIA, 2013). The second one is Bab El-Mandab located in the Red Sea (between Yemen and Djibouti) and sees 3.8 million barrels of oil moved per day. As these chokepoints are crucial to global energy security, the blockage of one of them can lead to substantial increases in energy costs.

ChokeYemen

(Source: Reuters)

The ‘Chinese Octopus’

Even though the US are still the major consumers of Oil in the world (20 million barrels a day, roughly 21% of global production), China surpassed the as the world’s largest net importer of oil (6.7ml b/d vs 5.1ml b/d for the US). As you can see it in the map below, China relies heavily on imports from the Middle East and therefore must closely follow the situation there. According to EIA, the main crude oil imports for China in 2011 were split between Saudi Arabia (20%), Angola (12.3%), Iran (11%), Russia (7.8%) and Oman 7.2%). This is what I call the ‘Chinese Octopus’ and why I think that Middle East concerns clearly matter for China.

ChineseOctopus

(Source: EIA)

Latest News

Tensions are intensifying, since Saudi Arabia launched the air campaign on March 26 to try to contain the Houthis and restore President Hadi, who has fled Aden for refuge in Riyadh (Saudi Arabia). The Houthis now control the capital Sana’a and have advanced on the southern city of Aden. According to the World Heath Organisation, 550 people have been killed and 1,800 injuries since March 19. See chart below for Houthis’ progress in Yemen.

HouthisP

(Source: American Enterprise Institute’s Critical Threats Project)

As you can see it in the map below, another opposing group is AQAP (Al-Qaeda in the Arabian Peninsula) which opposes both the Houthis and President Hadi.
ISIS is also present there, though still small, and opposes the government, the Houthis and AQAP.

AvY

(Source: American Enterprise Institute)

References:

Helen Lackner (2014), Why Yemen Matters.

Peter Salisbury (Feb 2015), Yemen and the Saudi-Iranian ‘Cold War’